An overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation.

Qualified Plan Transactions

Sec. 415 Limits

The IRS released guidance on the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) increases in the Sec. 415 contribution and benefit limits. In question-and-answer form, Rev. Rul. 2001-51 (1) addressed (1) allowable benefit increases and their effect on other qualification requirements, (2) plan amendments and (3) the sunset provision.

Prior to the EGTRRA effective date, the defined benefit dollar limit was $140,000 for 2001; under EGTRRA Section 611(a), it increased to $160,000 starting in 2002.

Annual additions credited to a participant's account under a defined contribution plan cannot exceed the Sec. 415(c) limits. For 2001, that limit was the lesser of (1) 25% of a participant's compensation or (2) $35,000. EGTRRA Sections 611 (b) and 632(a)(1) increased these thresholds to the lesser of (1) 100% of compensation or (2) $40,000, starting in 2002.

EGTRRA Section 901 contains a sunset provision; all EGTRRA provisions and amendments do not apply to tax, plan or limitation years after 2010. Rev. Rul. 2001-51 addresses many issues raised by the EGTRRA changes to Sec. 415 and should be quite useful to practitioners and plan administrators alike.

Qualified Plan Cases and Rulings

Partial Termination

The Supreme Court denied certiorari and vacated and remanded Matz v. Household Int'l Tax Reduction Investment Plan, (2) effectively affirming the Seventh Circuit's holding that only nonvested participants need to be counted in determining whether a qualified plan partially terminated.

Matz worked for Hamilton Investments, a subsidiary of Household International; he participated in its Sec. 401 (k) plan, which provided for employee deferrals and matching contributions. The matching contributions were subject to a vesting schedule.

In August 1994, Household sold some of its subsidiaries, including Hamilton Investments. Matz was 60% vested when he could no longer participate in the Household plan because of the sale. Believing that a partial termination of the Household plan had occurred that would have entitled him (as an affected employee) to be fully vested in his employer contributions, he sued to enforce his rights.

Seventh Circuit's original analysis:

Citing Weil v. Retirement Plan Admin. Committee (3) (in which the Second Circuit invited an amicus brief from the IRS), the Seventh Circuit gave great weight and deference to the IRS view that both vested and nonvested plan participants' must be counted in determining whether a partial termination has occurred. Because the IRS is the agency responsible for administering the statute, the court reasoned that the IRS's interpretation must be followed as long as it is reasonable. The court reached this conclusion even though it opined that counting only nonvested employees was a better policy.

The court further found that neither the statute nor the legislative history specify whether aggregation of years is permissible when determining whether a partial termination has occurred. The IRS has not taken a position on this issue. The Seventh Circuit held that nothing in the rule requires that only a single year's events be considered in making this determination.

Supreme Court's analysis: The Supreme Court vacated the Seventh Circuit's decision and remanded the case for further consideration in light of Mead Corp. (4) In Mead, the Court tried to delineate levels of deference owed to administrative agency pronouncements. The Court held that the highest level of deference is required when Congress has expressly or implicitly indicated that it intended the agency to speak with the force of law on a point, and the agency's position is reasonable. The Court explained that Congress generally indicates its intent when it provides for a relatively formal administrative procedure (such as "notice and comment rule making" or formal adjudication in a statute). When formal procedure is absent, an agency's pronouncement may still be entitled to deference if it is well reasoned and persuasive.

Remand: On revisiting Matz, the Seventh Circuit held that in determining whether a partial termination has occurred, only nonvested participants need to be counted. The court concluded that the position set out in the IRS's amicus brief (i.e., counting all participants) was not the result of a formal procedure and, thus, would be entitled to deference only if the court found it persuasive. The court found the IRS's position reasonable, but not persuasive.

The Supreme Court's vacating of the first Matz decision did not effect the multi-year issue; thus, the Seventh Circuit's original holding on that issue was undisturbed. The Court denied Matz's certiorari petition.

Given the conflict between the Second Circuit's Weil holding and the Seventh Circuit's Matz holding, the Supreme Court's denial of certiorari can be read as affirming the Seventh Circuit's stance.

The IRS's position dates to the early 1970s and is clearly set out in its "Plan Termination Handbook" which states, "[t]he Service takes the position that, in general, fully vested terminatees are included in determining whether there has been a partial termination."

Demutualization and Sec. 4980

The IRS ruled (5) that a defined benefit plan can be amended to distribute demutualization proceeds to plan participants after its termination, without violating Sec. 4980.

Employer is an S corporation that maintained a defined benefit plan and a profit-sharing plan. The defined benefit plan was terminated by a board resolution stating that excess assets were to be used to increase benefits for active plan participants. Employer filed Form 5310, Application for Determination for Terminating Plan, and the IRS issued a favorable determination letter. The defined benefit plan's assets were distributed; all participants received the full value of their accrued benefits. There were no surplus assets.

At the time the plan was terminated, its assets were invested in group annuity contracts issued by a mutual insurance company. After termination, the mutual insurance company became a stock insurance company. The insurance company wrote to Employer that insurance company stock had been issued to Employer on the defined benefit plan's behalf. Employer established a separate account solely to hold the insurance company stock (or the proceeds therefrom). The defined benefit plan required surplus assets to be returned to Employer.

Ruling request: Employer requested a ruling as to whether the demutualization proceeds could be treated as assets of the terminated defined benefit plan and used to increase participants' benefits. It also requested a ruling that, if the demutualization proceeds were used to pay benefits and expenses for calculating them, there would not be a reversion of plan assets to Employer, nor Sec. 4980 excise tax.

Sec. 4980(a) imposes an excise tax on an "employer reversion" from a qualified plan. Sec. 4980(c)(2)(A) provides that an employer reversion does not include any amount distributed to (or on behalf of) any employee if such amount could have been distributed before plan termination without violating Sec. 401.

When the defined benefit plan terminated, all the assets were distributed to beneficiaries; there were no surplus assets. The demutualization, in effect, caused the defined benefit plan to have post-termination assets. Because the assets from the demutualization were not known at termination, they could not have been distributed at that time. The stock issued at the demutualization was held in a separate account and not used by Employer. Under the plan terms, the demutualization assets could revert to Employer. Employer stated that it did not want to receive any of the assets resulting from the demutualization and would like them distributed to participants as benefit increases. For these purposes, Employer said it would amend the plan to increase participants' benefits.

Service's ruling: The IRS concluded that the demutualization assets could be treated as defined benefit plan assets for Sec. 4980 purposes. Because the plan is treated as having assets, plan participants can get these assets if their benefits are increased. For Sec. 4980 purposes, assets held in a separate account will be treated by the IRS as defined benefit plan assets. The plan will be treated as still existing and may be amended to increase benefits.

The IRS ruled that if the plan is amended to increase benefits and the amendments do not disqualify the plan, the demutualization assets could be paid to plan participants and their beneficiaries. Because Employer will not get any assets, there will be no reversion subject to the Sec. 4980 excise tax.

Qualified Replacement Plan

The IRS ruled (6) that no more than 25% of a reversion resulting from a termination of a defined benefit plan can be transferred to a qualified replacement plan without including the amount in the employer's gross income.

When an employer terminated its defined benefit plan, the plan's assets exceeded its liabilities. The employer proposed to transfer the surplus assets to a new profit-sharing plan that would cover 99% of the employees covered by the former defined benefit plan. If the transferred amount cannot be allocated to plan participants' accounts in the transfer year, the balance will be allocated to a suspense account, to be allocated to participants' accounts ratably over seven years, either in place of employer contributions or to supplement them. Amounts released from the suspense account will be treated as employer contributions for Secs. 401(a) and (m) and 415 purposes.

The IRS stated that only the first 25% transferred to the qualified replacement plan is excluded under Sec. 4980(d)(2)(B). (This position is contrary to Letter Rulings 9839030 and 9839031. (7))

The IRS also noted that Sec. 4980(d)(2)(C) provides for the allocation to a suspense account of only 25% of the surplus described in Sec. 4980(d)(2)(B)(i). Accordingly, if more than 25% of the surplus is allocated to a qualified replacement plan suspense account, the plan's tax-qualified status becomes an issue. Because the amount in excess of 25% of the surplus is treated as a reversion regardless of the transfer, such amount is treated as an employer contribution to the replacement plan on its transfer to that plan. This amount is subject to Sec. 404 deduction limits and the excise tax on nondeductible contributions in Sec. 4972.

The IRS stated that the Code does not specify whether the allocation of the surplus must be in place of an employer contribution or in addition to it. Contributions are limited by Sec. 415(c).

Rollover Distributions

The IRS ruled (8) that settlement distributions made to compensate present and former defined benefit plan participants for improperly calculated lump-sum distributions were not Sec. 402(c) "eligible rollover distributions," because amounts were paid from the employer's general assets, not from a qualified trust.

Participants and former participants sued Plan X (a defined benefit plan) and Company A in a class-action suit, alleging that the lump-sum payments were miscalculated, by using an improperly high interest rate. A settlement was approved by the court, under which Company A transferred amounts into Fund F. The fund was responsible for calculating and distributing amounts payable to class members.

The IR'S acknowledged that the Fund F distributions were for amounts that had been due from Plan X, but the settlement proceeds were actually paid from Company A's general assets, not from funds held in the Plan X trust. Sec. 402(c) provides that only distributions from qualified trusts are eligible rollover distributions. Thus, the IRS ruled that it was inappropriate to treat the Fund F distributions as being made from Plan X for Sec. 402 purposes. Because the Fund F distributions were not made from a qualified trust, there was no Sec. 402(c) eligible rollover distribution.

IRAs

Failed Roth Conversion

A significant Service Center Advice (9) (SCA) issued by the Chief, Qualified Plans (Employee Benefits) of the IRS's Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities Division (TEGE)) concluded that (1) a failed Roth IRA conversion resulted in a distribution from a traditional IRA and (2) the IRS's Taxpayer Advocate does not have authority to permit recharacterization.

In 1998, a taxpayer attempted to convert a traditional IRA to a Roth IRA, believing that his modified adjusted gross income (MAGI) for 1998 was less than $100,000. The taxpayer chose to include the income realized from the conversion over a four-year period, as authorized by Sec. 408A(d)(3)(A)(iii).

On April 15, 2000, the IRS issued an underreporter notice stating that the taxpayer's MAGI exceeded $100,000 for 1998. He filed an amended 1998 return seeking a refund of the taxes paid on the Roth conversion. The taxpayer contended that the IRA could not be recharacterized before the Dec. 31, 1999 deadline set out in Ann. 99104, (10) because he did not know his true income on that date.

According to the IRS, the taxpayer's failed Roth IRA conversion resulted in a distribution from a traditional IRA in 1998 (includible in his 1998 income) and an excess contribution to the Roth IRA (subject to the Sec. 4973 6% excise tax).

The SCA addressed three issues:

1. Does a failed Roth IRA conversion result in a distribution from a traditional IRA, including the imposition of the 10% additional tax on early distributions and a 6% excise tax on excess contributions to the Roth IRA?

2. Does the Taxpayer Advocate have discretion to allow a taxpayer to recharacterize a failed Roth IRA conversion after the deadline for recharacterizing an IRA contribution?

3. How should taxes and penalties attributable to a failed Roth IRA conversion be assessed and collected?

The IRS held that if a failed Roth IRA conversion is not recharacterized, the amount the taxpayer attempted to convert is treated as a regular distribution from a traditional IRA. A 10% excise tax is imposed on early distributions (unless an exception in Sec. 72(t) applies). The distribution is also treated as a regular contribution to a Roth IRA (subject to the statutory limits).

Further, a contribution in excess of the statutory limits is an excess contribution subject to a 6% excise tax. (11) If a taxpayer makes a failed Roth conversion and the date to recharacterize it has passed, he or she may seek relief under Regs. Sec. 301.9100-3 via a letter ruling request from the TEGE.

The IRS stated that the Taxpayer Advocate does not have discretion under the Code or delegation orders to allow a taxpayer to recharacterize a failed Roth IRA conversion. (12)

The "math error" exception to the use of normal assessment procedures may only be used when the face of the return clearly indicates which entry is incorrect. For a failed conversion due to unreported income, no return entry is obviously in error. (13)

IRA Transfer by Beneficiary

The IRS ruled (14) that one of many beneficiaries of a decedent's IRA may transfer his or her subaccount in the IRA to a new IRA in the deceased's name and preserve the lifetime payout.

Citing Rev. Rul. 78-406, (15) the ruling concludes that a beneficiary may transfer the share of the late grantor's IRA to a new IRA created and maintained in the grantor's name. The beneficiary is treated as the designated beneficiary of the transferee IRA. Further, Rev. Rul. 78-406 does not hold that the full amount in an IRA must be transferred; the beneficiary can transfer the share without regard to whether the siblings transfer portions in the grantor IRA.

ESOPs

Redemption Nondeductible 

The Tax Court ruled that an employer's redemption of shares distributed from an ESOP was nondeductible. (16) Chrysler Corporation was in such financial distress in the late 1970s that Congress enacted the Chrysler Corporation Loan Guarantee Act of 1979 (LGA), under which the Federal government guaranteed some of its loans. LGA provisions required Chrysler employees to make wage and benefit concessions of at least $587.5 million and for the company to establish an ESOP and fund it with at least $162.5 million of Chrysler common stock over four years.

Chrysler created the ESOP and funded it with new stock. Participation was limited to employees with at least nine months service who had been affected by the LGA'S wage and benefit concessions. Chrysler transferred over 15 million shares (worth over $162 million) into the ESOP between 1980-1984; the ESOP held the largest block of outstanding shares (22% of all shares outstanding). Dividends were invested in more shares.

In 1985, as part of the collective bargaining process, Chrysler agreed to terminate the ESOP and allow participants either to keep the shares distributed to them or to allow the company to redeem the shares at the applicable closing price on the New York Stock Exchange. Chrysler redeemed over nine million shares for over $400 million. ESOP participants who decided not to sell received over three million Chrysler shares.

On its 1985 Federal income tax return, Chrysler deducted more than $327 million for the redemption of the ESOP shares, as either compensation for personal services or as a financing expense. The IRS disallowed the deduction.

Tax Court's analysis: Holding for the IRS and denying the deduction, the court followed a line of cases that examined an expense's origin or character to determine its deductibility, rather than the consequences to the taxpayer. (17) The court also concluded that the payments were not a substitute for wages, but were triggered by the employee/shareholders' demand that Chrysler redeem their shares.

Liquidation Payments

The IRS ruled (18) that a liquidation payment from a bankrupt employer to an ESOP did not give rise to annual additions. Further, the offset of a liquidation payment by the unpaid balance of the exempt ESOP loan was not a prohibited transaction.

In the ruling, Employer, an insurance company, established an ESOP effective Jan. 2,1992 that met the Secs. 401(a) and 4975(e)(7) requirements. In June 1992, the ESOP borrowed $1 million from Employer to buy 416,000 shares of employer stock in an exempt loan transaction intended to meet Sec. 4975(d)(3). The amount borrowed was secured by the acquired stock. The loan agreement required 10 equal annual payments. In the event of default, the loan was due and payable with interest. The 416,000 shares were allocated to a suspense account (as described in Regs. Sec. 54.4975-11 (c)).

Employer intended to make contributions to the ESOP so that it could repay the exempt loan and allocate shares released from the suspense account to plan participants. In 1992, Employer made one installment payment and an additional principal payment; as a result, 52,000 shares were released from the suspense account and allocated to participants' ESOP accounts.

Before the second annual loan installment was due, the state insurance department determined that Employer was insolvent, and court proceedings were begun to liquidate it. The state insurance director was appointed as Employer's receiver.

In January 1994, Employer's board of directors terminated the ESOP and received a favorable IRS determination letter in November 1994. On termination, the stock allocated to participants' accounts and the ESOP'S cash were paid to participants. In 1998, the ESOP's trustees fried a claim in Employer's liquidation proceedings. No action was taken as to the employer stock in the ESOP'S suspense account, because it was thought the stock was worthless.

As Employer's liquidation approached completion, its assets exceeded the approved claims; thus, there was a liquidating distribution of cash to shareholders (including the ESOP). Employer intended to offset, against the cash it was to pay the ESOP, any unpaid balance (and any other charges) of the loan due Employer from the ESOP. The ESOP would return its employer stock to Employer as part of the transaction. The net amount to be paid by Employer to the ESOP was $12 million.

Employer requested two rulings, that the:

1. Setoff of the amount due from Employer by the amount owed to Employer by the ESOP would not cause the ESOP to fail to meet Sec. 4975.

2. Allocation of the liquidating distribution would not be an annual addition under Sec. 415.

The IRS ruled that the setoff did not cause the ESOP to violate Sec. 4975, because Regs. Sec. 54.49757(b)(3) states that all the facts and circumstances must be evaluated when determining whether an ESOP loan is primarily for the participants' benefit. Under Regs. Sec. 54.4975-7(b)(5) and (6), only employer stock, its earnings and employer contributions may be used to pay an exempt loan. Employer stock pledged as collateral may be used to pay an exempt loan in default. Because Employer was being liquidated and the ESOP had been terminated, the exempt loan was to be repaid by the setoff against the distribution the ESOP was to receive from its position as a shareholder of Employer. Considering all the facts and circumstances, the IRS ruled that the setoff did not cause the ESOP to violate Sec. 4975.

Because the liquidation payment was not an employer or employee contribution or forfeiture, these amounts were not annual additions as defined in Sec. 415(c) (2). The IRS also ruled that the facts and circumstances did not support recharacterizing the proceeds that the ESOP will receive from Employer's liquidation as annual additions, as permitted by Regs. Sec. 1.415-6(b)(2)(i).

Conclusion

In the next issue, Part II of this article will focus on executive compensation, health and welfare and fringe benefits.

Authors' note: The authors acknowledge the significant contributions of Karen Field, Robert Masnik, Tracey Schlabach, Pamela Hobbs and Robert Delgado, of KPMG LLP's Washington National Tax Compensation and Benefits Practice, in compiling information for this article.

(1) Rev. Rul. 2001-51, IRB 2001-45, 427.

(2) Robert J. Matz v. Household Int'l Tax Reduction Investment Plan, ND IL, 9/8/00, aff'd, 227 F3d 971 (7th Cir. 2000); cert. granted, rev'd and rem'd, 533 US 925 (2001); on remand, rev'g and rem'g ND IL, 265 F3d572 (7th Cir. 2001), cert. den.

(3) Warren Weil v. Retirement Plan Admin. Committee, 933 F2d 106 (2d Cir. 1991).

(4) Mead Cop., 533 US 218 (2001).

(5) IRS Letter Ruling 200214031 (12/13/01).

(6) IRS Letter Ruling 200212035 (12/28/01).

(7) IRS Letter Ruling 9839030 and 9839031 (both dated 6/29/98).

(8) IRS Letter Ruling 200213032 (1/02/02.

(9) SCA 200148051 (9/20/01).

(10) ann. 99-104, 1999-2 CB 555.

(11) See Sees. 408(d) and 408A(3)(B); Regs. Sec. 1.408A-4, Q&A-2, -3 and -8 and 1.408A-5, Q&A-1 and-6(b).

(12) See Sec. 7803(c).

(13) See Sec. 6213 and GCM 39019 (8/3/83).

(14) IRS Letter Ruling 200208029 (11/26/01).

(15)Rev. Rul. 78-406, 1978-2 CB 157.

(16) Chrysler Corp., TC Memo 2001-244.

(17) See Don Gilmore, 372 US 39 (1963).

(18) IRS Letter Ruling 200210065 (12/11/01).

RELATED ARTICLE: EXECUTIVE SUMMARY

* The IRS released guidance on the EGTRRA increases in the Sec. 415 contribution and benefit limits.

* The Supreme Court effectively affirmed a Seventh Circuit holding that only nonvested participants need to be counted in determining whether a qualified plan partially terminated.

* According to the IRS, a failed Roth IRA conversion resulted in a distribution from a traditional IRA and the Taxpayer Advocate does not have authority to permit recharacterization.

Gary Q. Cvach Partner KPMG LLP Washington, DC

Terrance E Richardson Senior Manager KPMG LLP McLean,VA

Terri L.E. Stecher Senior Manager KPMG LLP Washington, DC